A surge in purchases of emerging market debt and a dip in buyers' appetite for U.S. Treasury bonds has sparked speculation that developing nations have become the next safe haven for bond investors. But the more likely scenario is a reversal of capital flows that will sustain Treasury debt for a little while longer.

Emerging market bonds have enjoyed the best first quarter on record as new issuance has surged and interest rate spreads over U.S. Treasuries have narrowed to their lowest since 2008.

Sovereign bond markets in developing countries have sold a record $157 billion so far this year, a 42% jump over the same period in 2009, which marked the previous record, according to data from Dealogic Holdings plc.

Developing-nation bond issuers had the busiest start to a year since Bloomberg began compiling the data in 1999, as the yield on JPMorgan Chase & Co.'s (NYSE: JPM) benchmark EMBI Global Diversified Index fell as low as 6.22% on March 17.

The spread between U.S. Treasuries and emerging market bonds has been tightening since March last year. They narrowed even farther in the past two weeks after Greece's new debt offering at the start of the month stabilized markets.

Emerging market yields narrowed to 2.57 percentage points over U.S. Treasuries last week compared with 3.5 percentage points a month ago, according to the JPMorgan index.

By comparison, the spread reached a recent peak of 6.84 percentage points in March 2009. The spread now represents a fraction of the record peak of 16.64 percentage points in September 1998, after the Asian debt crisis.

However, some analysts are preaching caution, saying that interest rate spreads over benchmark bonds have tightened too quickly, warning that a sell-off may be imminent.

According to Money Morning Contributing Editor R. Shah Gilani, the capital outflow to emerging markets is not sustainable and may peak in the next few quarters, or sooner.

"When the world financial crisis started to lose its momentum, the spread of foreign credits over U.S. treasuries was so fantastic that it became an academic move to ride the narrowing risk premium," said Gilani who recently introduced a new advisory service – The Capital Wave Forecast– that targets the movements of big capital flows around the planet. "Those spreads have collapsed and the dollar carry trade is getting long in the tooth."

Bond investors in markets such as Indonesia and Brazil may be particularly vulnerable, after the value of their government bonds soared in recent months.

Indonesian five-year bond yields have fallen to 3.77%, down from 9.49% when the debt was issued in February last year, meaning the country is paying a mere 1.38 percentage points over U.S. Treasuries versus 7.58 percentage points last year.

"It is a good time for investors to take some profits and wait for a better time to buy as the market is almost certain to fall in the next few months," said Nigel Rendell, senior emerging markets strategist at RBC Capital Markets.

Strength in Emerging Economies Draws Investors

Investors have flocked to emerging market debt seeking shelter from the financial meltdown that has crippled developed economies.

And while the short-term fundamentals are attractive, long-term drivers of financial market growth remain strong in developing economies. Many have high national saving rates, creating large sources of capital to invest. They typically have very large infrastructure investment needs that require financing. And their financial markets are much smaller relative to GDP than those in mature markets, leaving room for growth .

Action on Treasuries Slows

The flow of capital towards developing countries' debt has also been reflected in the tepid response to recent Treasury auctions.

Foreign investors, led by central banks, were net sellers of all U.S. securities in January, according to the Treasury Department.

China is still the largest holder of U.S. government debt, holding $889 billion in January, down from $894.8 billion in December. Japan was second with $765.4 billion, down about $300 million from the prior month.

Net outflows from all U.S. securities, including short-term instruments such as Treasury bills, totaled $33.4 billion in January, reversing a $53.6 billion inflow seen in December.

Central banks were the biggest sellers, unloading a record $34.1 billion, the most since they sold $26.3 billion in September 1998 following financial crises in Asia and Russia.

After weaker-than-expected demand for $118 billion in government notes last week, investors will keep a close eye on the supply. Slackening demand at the auctions could fuel worries over the unprecedented high level of federal deficits and the huge amount of debt sales needed to fund the shortfall, which would lift bond yields and raise borrowing costs for consumers and businesses.

Is Debt Rating in Danger?

Unexpectedly weak demand has led some observers to believe the U.S. could be in danger of a ratings downgrade.

But the report added that these governments' margin for error "has in all cases substantially diminished," thanks to a weak outlook for economic growth and the enormous debt loads issued to alleviate the financial crisis of 2008-2009.

"Preserving debt affordability…will invariably require fiscal adjustments of a magnitude that, in some cases, will test social cohesion," the analysts wrote.

Interest payments on general government debt in the U.S. could rise above 10% of revenue by 2013, according to the Moody's report.

That's the level at which the ratings agency typically considers a downgrade.

Gilani thinks America's creditors will eventually demand higher rates of interest in order to compensate them for the risks involved in loaning money to the free-spending United States.

"The U.S. is not technically a AAA credit risk in terms of ratios and other standard debt instrument metrics. We're not even AA credit," said Gilani. "That doesn't mean the U.S. will ever default. It means that realistically, it's going to cost us more to finance our existing debt and new expenditures."

U.S. Debt Spiraling Upwards

The government's debt has almost doubled in the last two years alone, as Americans' personal wealth sank along with housing and stock prices. And the party isn't over yet.

In fact, the U.S. debt crisis is only just beginning.

Back in early February, when the White House Office of Management and Budget (OMB) released its Fiscal 2011 budget, the Obama administration projected a 10-year deficit total of $8.53 trillion.

Looking only at short-term debt, the Treasury will have to finance at least $3.5 trillion worth of maturing debt in the next 18 months, an amount equal to nearly 30% of our entire GDP. These large debts represent a significant transfer of wealth from future generations to today's populations and will be a drag on growth as they are paid down in the future.

Gilani says that while that could be a prescription for disaster, we've still got a grace period before the debt problem comes home to roost.

"It will be a stock pickers market when rates rise and the dollar falls. But, I don't see the problems beginning to take root," he says. "We need to watch the shape of the curve, real rates and credit availability. When these three indicators turn negative, its time to take cover, the new, new abnormal will have begun."

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